Capital One Financial announced plans late last month to acquire Discover Financial Services in a $35.3 billion deal that would give Capital One its own credit-card payment network, while simultaneously allowing the company to expand its deposit base, credit-card offerings, and rewards programs.
Conversely, credit analysts like Matt Schulz of LendingTree note that “if Capital One sees that there’s a bunch of overlap between what they have and what Discover brings to the table, and they want to combine the two instead of keeping them as separate brands, you could end up seeing some of those offers get reduced.” The Wall Street Journal reports that Capital One intends to maintain the Discover brand and shift some of its debit and credit cards from the Visa and Mastercard payment networks to Discover’s payment network.
The proposed deal requires shareholder approval, as well as regulatory approvals from the Federal Reserve Board, Office of the Comptroller of the Currency (OCC), and the Federal Deposit Insurance Corp. (FDIC). Although it is expected to take a year to consummate, and even longer for its effects to be felt, the deal has already been condemned from some quarters.
The critics include Sens. Josh Hawley (R-Mo.) and Elizabeth Warren (D-Mass.), who have demanded that regulators block it. Warren claims that, by increasing concentration in the credit-card sector, the deal would erode financial stability, reduce competition, and hurt consumers through higher fees and credit costs. The deal could also be challenged by the U.S. Justice Department (DOJ), which has promised increased scrutiny of financial-sector mergers. It will also be carefully scrutinized by the OCC, which recently announced changes to its merger-review process that are in-line with Biden administration statements promising to combat the perceived issue of merger-driven concentration in the banking sector.
Analyzing the Deal
The merged firm would be the sixth-largest bank in the United States by total assets and deposits. It will also be the country’s biggest credit-card issuer, with a market share of 19%, ahead of current market leader JPMorgan Chase’s 16%.
Capital One and Discover differ significantly, however, in their operations and business models. Capital One is the ninth-largest U.S. bank, with roughly 260 branches nationwide. Like most card issuers, it issues credit cards to its customers primarily through the Visa and Mastercard payment-processing networks. Conversely, Discover operates just one full-service branch, and issues credit cards through its own payment-processing network, which is the fourth-largest nationwide, behind Visa, Mastercard, and American Express.
More importantly, while Visa and Mastercard operate so-called “four-party” networks and are not themselves direct issuers, Discover’s business model is broadly similar to that of American Express, in that while both firms offer some “four-party” network services, they primarily serve as “three-party” networks for cards they issue themselves. The four major payment networks also vary in terms of merchant acceptability, fraud protection, their ability to offer benefits and rewards programs, and foreign transaction fees. As WalletHub notes:
Visa and Mastercard boast a significant advantage in terms of worldwide acceptance, while Amex and Discover supplement their payment facilitation business by issuing cards directly to consumers. Card network rental car insurance, extended warranty, and fraud liability policies vary widely as well.
As the merger would give Capital One access to its own payment network, it represents both a horizontal merger and vertical integration. When it comes to the horizontal merger, the merged entity’s 19% share of the credit-card issuer (or revolving small loan) market is well below the threshold that would typically raise regulatory concerns about market power sufficient to substantially reduce competition.
When it comes to vertical aspects of the merger, U.S. antitrust law is concerned with whether the merged entity would have both the incentive and ability to reduce competition and harm consumers. To its credit, as my Mercatus Center colleague Alden Abbott notes:
Capital One has used recent acquisitions to create new products that generate economic benefits, including enhancements in Capital One Shopping (through the acquisition of Wikibuy), Capital One Travel (through a partnership with Hopper), and Capital One Dining (through a collaboration with SevenRooms). These improvements make consumers better off.
Analyzing the Market
To understand the likely implications of the merger, we must consider the history and current status of Discover, as well as the nature and circumstances of the credit-card market. Though it is the fourth-largest credit-card payment network in the country, Discover significantly trails its three larger rivals, and its share of balances as a credit-card issuer is just 8%, behind Capital One’s 10%.
Among the four major credit-card networks, Discover accounts for just 4% of the market by purchase volume, well behind Visa (52.6%), Mastercard (23.7%), and even American Express (19.6%). In terms of number of cards in circulation, as of 2022, Discover fared slightly better, with a market share of 7.13%, only slightly behind American Express’ 10.17%. This suggests that, among the two credit-card networks that issue their own cards, American Express customers tend to use the cards more extensively than Discover customers, despite their similar business models. Here too, Visa (41.7%) and Mastercard (27.4%), who exclusively offer their network to other card issuers (including banks like Capital One) are well ahead as market leaders.
It is no surprise, then, that Capital One and various financial analysts present the acquisition as an opportunity to create a powerful competitor that can challenge the dominance of Visa and Mastercard. The two top payment networks have been criticized for high fees, with Visa currently facing a DOJ investigation over the same. Capital One customers account for $300 billion in American credit, 10% of the total credit-card volumes of the Visa and Mastercard networks, giving them the opportunity to steer a large volume of customers and transactions to the Discover network. This poses a significant potential competitive threat.
The merger could also give the combined entity the economies of scale and transaction volume necessary to improve rewards-program offerings, offer improved security and fraud protections, or lower card-transaction fees, thereby placing further competitive pressure on the other networks. Consider that Discover originally got its start in 1985 as a division of the Sears retail chain, in an era when Sears was such a significant retailer that its card offering was a viable competitor to the longstanding incumbent card networks. Capital One notes that the merged firm would bring together more than 100 million customers.
Discover’s lack of scale economies, given its smaller customer base, have historically handicapped the firm. Though it does continue to distinguish itself by not charging annual fees, the company’s 1990s-era strategy of branding itself as a lower-fee alternative to Amex that could attract merchants by charging them lower fees to use its network were hampered by Amex’s use of vertical-trade-restraint contracts with merchants. These forbid merchants from steering or incentivizing customers to pay through any other credit-card payment network if they wanted to continue to use the Amex network. Given the high volume of transactions from Amex customers and the tendency of Amex customers to shop elsewhere if stores refused to accept Amex, most major merchants in the United States chose to accept these restraints rather than forgo access to Amex’s network.
The U.S. Supreme Court confirmed the legality of Amex’s restraints on steering customers in the 2018 American Express v. Ohio decision. They found that the restraints have procompetitive benefits in the two-sided credit-card market by supporting Amex’s generous rewards programs, as keeping Amex customers within their card network ensures the network’s continued viability, as well as its ability to bring higher purchase volumes to merchants.
The decision does remain controversial among some law and economics scholars and segments of the financial-sector policy community, as the court found evidence that Amex’s ability to charge merchants higher fees that benefit Amex customers resulted in merchants raising fees that were passed on to customers who do not use Amex cards (among other purported anticompetitive effects). Conversely, other scholars have supported the ruling for recognizing dynamic competition in two-sided markets, and the procompetitive benefits of steering restraints in enabling firms like Amex to fund generous rewards programs and more secure, reliable payment networks.
Whether Discover-Capital One will revisit the competitive strategy of competing by lowering fees is uncertain, though there would likely be at least some cost savings where merchants and the card issuer (Capital One) use the same bank. The combined entity may instead choose to maintain or even increase their fees. This does not, however, necessarily mean that customers would be worse off. For instance, interchange fees charged to merchants frequently support payment-network development, rewards programs, and enhanced security and fraud prevention.
The merged firm may even choose to compete with Visa and Mastercard in the “four-party” card market, as Discover already does to a limited extent. It is also possible that the merged firm could use its synergies and cost savings to both lower fees for merchants and customers and expand rewards programs, cybersecurity and other features. All three of these possibilities constitute increased competition and a challenge for Capital One and Discover’s competitors.
Capital One anticipates that the merger will generate $1.5 billion in cost synergies and $1.2 billion in network synergies in 2027. The merger would also generate other welfare-enhancing, pro-competitive efficiencies:
- Branch and ATM access: Discover checking- and savings-account customers would gain access to Capital One’s 259 branches and 55 cafes. The combined entity’s customers could also use more than 80,000 fee-free ATMs across the United States and deposit cash in more than 16,000 locations.
- Merchant acceptance: Though American Express and Discover have historically lagged Visa and Mastercard in terms of merchant acceptance, both are now accepted by more than 99% of U.S. merchants. They do still lag Visa and Mastercard in international-merchant acceptance. Discover debit cards currently work for foreign purchases and ATM withdrawals at participating businesses, mainly within North America. The merged firm would have greater ability to negotiate deals with foreign and domestic merchants than Discover has by itself. As Investor’s Business Daily reports, “Discover is currently accepted at about 70 million merchants, compared to Mastercard at around 100 million and Visa’s 130 million, making it the smallest of the four U.S.-based global payments networks.” Capital One notes that the merger would create “a global payments platform at scale, with 70 million merchant acceptance points in more than 200 countries and territories.”
- Credit access and consumer choice: As reported by CBS News, “Capital One has long ha[d] a business model looking for customers who will keep a balance on their cards, aiming for customers with lower credit scores than American Express or even Discover.” Capital One customers with lower credit scores could feasibly gain access to Discover card offerings that were previously unavailable to them. The higher card balances of Discover’s customer base, $102 billion in total, would also benefit Capital One and give it the leverage to offer better terms to its existing customers by allowing it to better weather potential customer defaults.
- Improved technology and speedier tech rollout: Capital One has touted the value of its technology and data ecosystem, undertaking a “eleven-year technology transformation” which could be applied at a faster rate across a much larger customer base. Michael Imerman of the University of California at Irvine opines that “the combined bank would be in a position to be more competitive against digital banks and fintech competitors that have made significant progress moving upmarket in the consumer banking space in the past few years.”
In addition to these potential synergies, regulators and antitrust enforcers may also consider the relative position of Discover, which has faced challenges recently that hindered its ability to compete at its full potential. Last year, it was forced to set aside $365 million to cover liabilities arising from consumer-compliance process flaws and misclassification of its customers’ credit-card accounts, a controversy that was followed by the resignation and replacement of its CEO and president. Capital One’s resources could help Discover weather its setbacks, and to facilitate commitments that Discover has made to the FDIC to improve and secure its consumer-compliance processes.
Notably, and despite its concerns about mergers in the financial sector, the Biden administration has also nominally welcomed deals that could “rescue” struggling institutions, though it remains to be seen whether the administrative agencies and regulators will consider this to be applicable to Discover. Recent aggressive actions by Biden administration agencies, including the DOJ’s move to block JetBlue’s proposed acquisition of Spirit Airlines, indicate that their sympathies for struggling-firm arguments only go so far.
Conclusion
In evaluating the Capital One-Discover merger, regulators and antitrust enforcers should consider evidence of the above pro-competitive synergies, potential improvements and efficiencies, and the firm’s ability and incentives to pass these on to consumers. Conversely, a focus on superficial increases in market concentration that fail to account for the deal’s effects on the competitive process or consumers could lead to less competition in the credit-card market and harm to consumers and innovation. This would only benefit incumbent dominant firms, including those that are the current targets of antitrust investigation and scrutiny.